Amherst College Department of Economics Economics 111 Section 3 Fall 2012 Monday, October 22 Handout: Externalities and Efficiency Externalities Another Example of a Market Failure An externality exists whenever consumers or firms do not account fully for the ramifications of their actions. The effect that is not accounted for is called the external effect. Broadly speaking, two types of externalities exist: Negative externalities: Situations in which the external effect damages others; Positive externalities: Situations in which the external effect helps others. Preview: Externalities cause inefficiency. Remedies for externalities: o Fees (Taxes) or Bonuses (Subsidies) o Coase Approach (Private Solution) o Command and Control o Cap and Trade Classroom Exercise: Pollution and Efficiency A chemical firm and a farm are both located beside a lake. The chemical firm discharges waste water into the lake. Pollution is an unavoidable consequence of chemical production. The farm must use the lake water to irrigate its fields. Before the farm can use the water, the pollutants must be removed. Farmer s Fields Chemical Firm Waste Water The costs of cleaning the water are: Clean-up Costs = C F where C = quantity of chemical produced F = quantity of food produced Question: Clean-up costs depend on both chemical and food production. Is this realistic?
2 The following diagrams describe the marginal cost curves of the chemical and food firms: Chemical Firm Farm MC of Chemicals MC C = 200 + 2C MC of Food C = 400 C = 0 1,200 1,200 1,000 1,000 800 800 600 600 400 400 200 200 C 200 400 600 100 200 300 F Since the farmer s cost depends on the quantity of chemicals produced, the farmer has one marginal cost curve for each quantity of chemicals. As more chemicals are produced, the farmer s marginal cost curve shifts up reflecting the additional costs imposed on the farmer. Assume that both the chemical industry and the food industry are perfectly competitive. The price of chemicals is $1,000 and the price food is $800: Price of Chemicals = $1,000 Price of Food = $800 Suppose that initially the chemical firm produces 399 units of chemicals. Question: What does the chemical firm s marginal revenue equal? Answer: MR = $ Question: What does the chemical firm s marginal cost equal? Answer: MC = $ Question: How would the production of one additional unit, increasing production from 399 to 400, affect the chemical firm s total revenues, total costs, and profits? Profit = C=399 C=400 Question: How many chemicals will the profit maximizing chemical firm produce? Answer: C = Question: How much food will the profit farmer produce? Answer: F = Question: What are the clean-up costs? Answer: Clean-up Costs = C F = = $
3 Question: Is this state of affairs efficient? State of Affairs: C = F = Clean-up Costs = C F = = $ Efficiency: Is the economy getting the most from its limited resources? Pareto s Query: Given the state of affairs in question, is it possible to make one individual better off without hurting anyone else? Yes No Is the state of affairs getting the most Is the state of affairs getting the most from the economy s resources? from the economy s resources? State of affairs is. State of affairs is. Question: Can you devise a special deal that would benefit both the owner of the chemical firm and the farmer? Special Deal: Owner of Chemical Firm Farmer Efficiency Intuition: Prior to the special deal are decisions based on misleading or correct information? Misleading Information Correct Information Results Results Question: Why is there a problem here? Answer: More generally, Social Costs of Private Costs of Chemical Chemical Production Production Difference: Effect
4 Suppose that the chemical firm is ordered to close by the EPA thereby eliminating all pollution: C = 0. Question: How much food will the profit farmer produce? Answer: F = Question: Is this state of affairs efficient? State of Affairs: C = 0 F = Clean-up Costs = C F = = $ Question: Can you devise a deal that would benefit both the owner of the chemical firm and the farmer? Special Deal: Owner of Chemical Firm Farmer Remedies for Externalities Fees (Taxes) or Bonuses (Subsidies) Coase Approach (Private Solution) Command and Control Cap and Trade Fees (Taxes) or Bonuses (Subsidies) Question: Consider the chemical firm and farm. What is the basic problem? Answer: The chemical firm is not accounting for all the ramifications of its actions. It is not accounting for the fact that when it produces chemicals it is imposing a cost on the farmer. Chemical Firm Social Costs of Private Costs of MC of Chemicals MC Social Chemical > Chemical 1,200 Production Production 1,000 MC Private The government charges the owner of the chemical firm a fee for each unit of pollution the chemical firm dumps into the lake. 800 600 400 Question: What should the pollution fee equal? Answer: 200 200 400 600 C
5 Coase Approach (Private Solution) Efficiency: Is the economy getting the most from its limited resources? Pareto s Query: Given the state of affairs in question, is it possible to make one individual better off without hurting anyone else? Yes No Is the state of affairs getting the most Is the state of affairs getting the most from the economy s resources? No. from the economy s resources? Yes. State of affairs is inefficient. State of affairs is efficient. The Coase Approach to Externalities Coase suggested a way to remedy market failures which relies on getting the affected individuals together, bargaining, and striking deals. To motivate Coase s approach, consider the following: When will a deal be struck and when will it be impossible to strike a deal? Question: What must be true if two (or more) individuals voluntarily AGREE to a deal? Answer: At the very minimum, the deal must make individual better off; and make individual worse off. Question: What must be true if given the state of affairs in question, it is IMPOSSIBLE for two (or more) individuals to AGREE voluntarily to a deal? Answer: It must be impossible to find a way to make individual better off; and make individual worse off. The state of affairs in question must be. Coase Approach: Get the affected individuals together. Encourage them to bargain and strike deals. Continue this bargaining and deal making process until it is impossible for them to make any more deals. Question: Consider the state of affairs that is reached when it is impossible for the individuals to strike any more deals. Is this state of affairs efficient or inefficient? Answer:
6 Illustration of the Coase Approach: Mr. Smith, Ms. Jones, and a Wood Stove Mr. Smith is getting a new neighbor; Ms. Jones is building a house near Mr. Smith. Ms. Jones is deciding how to heat her house and has narrowed the options to two: electricity or wood. Electric heat would cost her $5,000 per year Wood heat costs $2,000 a year. Ms. Jones does not suffer from any respiratory problems; consequently, the fact that wood burning will pollute the atmosphere does not concern her. Furthermore, she is not the least bit troubled by the inconvenience that wood heat might cause her. Mr. Smith learns that Ms. Jones will be using wood to heat her home. Mr. Smith suffers from asthma. Consequently, his lungs cannot tolerate wood smoke. If the air were polluted by Ms. Jones wood smoke, he has no choice: he would be forced to install a climate control system in his home to filter the air. Climate control system costs $2,500 per year. Question: In view of the costs of the two fuels, would Ms. Jones use electricity or wood to heat her home? Answer: Question: How would Mr. Smith respond? Answer: Question: Who has the property rights to the air? Answer: A Possible Deal: Might Mr. Smith be able to bribe Ms. Jones to heat with electricity rather than wood? More specifically, would Mr. Smith offer Ms. Jones a sufficiently high side payment to induce her to switch to electricity? Question: What is the largest side payment Mr. Smith would possibly offer? $ Question: What is the smallest side payment needed to induce Ms. Jones to switch voluntarily from wood to electricity? $ Question: In the end, will Ms. Jones heat with electricity of wood?. Mr. Smith install the climate control system?. Society s Perspective: Two Goals Consider the dual goals of meeting: heating needs of Ms. Jones and air quality needs of Mr. Smith There are two ways to meet these goals: Ms. Jones heats with electricity; or Ms. Jones heats with wood and Mr. Smith installs the climate control system. Based on the collective costs of Ms. Jones and Mr. Smith, which approach is least costly? Ms. Jones heats with electricity Ms. Jones Costs = $ Total Costs to Society = $ Ms. Jones heats with wood and Mr. Smith installs climate control system Ms. Jones Costs = $ Mr. Smith s Costs = $ Total Costs to Society = $
7 Mr. Smith is distressed, so he lobbies Town Hall to prohibit Ms. Jones from using wood without his approval. Suppose that Town Hall supports Mr. Smith. Ms. Jones could now heat with wood only if Mr. Smith approves. Question: Now, who has the property rights to the air? Answer: A Possible Deal: Assuming that Mr. Smith and Ms. Jones are still speaking, might they be able to devise a mutually benefit deal, a deal that would make each of them better off? If so, what would the deal entail? Question: What is the largest side payment Ms. Jones would possibly offer? $ Question: What is the smallest side payment needed to induce Mr. Smith to agree? $ Special Deal: Ms. Jones Mr. Smith Question: In the end, will Ms. Jones heat with electricity of wood?. Mr. Smith install the climate control system?. Coase Theorem: If bargaining costs are negligible, bargaining leads to. Furthermore, the assignment of property rights o affect the allocation of resources; o affect the distribution of income.
8 Chlorofluorocarbons: Another example of an externality Approximately two decades ago, a total of 400 million pounds of chlorofluorocarbons were being emitted per year in the United States. There were three primary sources of CFC emissions: the manufacturing of urethane foam, automobile air conditioners, and cleaning solvents. 80 million pounds are emitted due to urethane foam production, 140 million due to automobile air conditioning, and 180 million due to cleaning solvents. The cost of eliminating the emissions from each source varies: Urethane Foam - 80 million pounds of emissions 30 million pounds of emissions could be eliminated at a cost of $.60 per pound. The remaining 50 million pounds could be eliminated at a cost of $1.00 per pound. Automobile Air Conditioner - 140 million pounds 20 million pounds could be eliminated at a cost of $2.50 per pound. The remaining 120 million pounds could be eliminated at a cost of $7.00 per pound. Cleaning Solvents - 180 million pounds 30 million could be eliminated at a cost of $.30 per pound. The next 90 million pounds could be eliminated at a cost of $.80 per pound. The remaining 60 million pounds could be eliminated at a cost of $1.50 per pound. Costs Per Pound of Reducing Emissions Industry Emissions Cost of reducing (millions of lb) (dollars per lb) Urethane 80 $.60 for first 30 M lbs recover and recycle $1.00 for remaining 50 M lbs replace with methylene chloride Auto Air 140 $2.50 for first 20 M lbs recover at servicing $7.00 for remaining 120 M lbs replace with HCFC-22 Solvents 180 $.30 for first 30 M lbs conservation $.80 for next 90 M lbs recover and recycle $1.50 for remaining 60 M lbs replace with other solvents Goal: Reduce emissions by 50 percent; that is, reduce emissions by 200 million pounds.